This change to the pensions death tax is huge – here’s all you need to know

At a dinner I attended last night (on the subject of Scottish devolution – more on this on the blog later), one of the men around the table made the case for abolishing inheritance tax (IHT). It collects so little money, he said, that it isn’t worth the effort.

He’s right of course. But rather than abolish what is effectively the UK’s wealth tax, we might ask why it raises so little. The answer is that it is one of the most easily avoided taxes ever.

And for all the talk of closing loopholes, it appears the chancellor has no plans of doing anything about that.

In fact, yesterday he announced some changes to the pensions system that will make it even easier for the well-off to place significant amounts of cash out of reach of the taxman on death.

And the eventual consequences could be a lot more far-reaching than that…

Another massive change to the pensions system

The next paragraph looks boring. But stick with it and you will soon see that – if you are of an age where the idea of IHT is beginning to bother you – it just isn’t.

At the moment, you can only pass your personal pension on to your heirs as a tax-free sum if you die before you are 75, and you have not yet started to draw down on it.

If you have drawn on it, or are over 75, the tax charge comes in at a hefty 55%. That rate is meant to reflect the fact that the money has already been subject to extensive tax relief.

Not any more. From April next year, if you die before you are 75, your heirs will get the money as a tax-free lump sum regardless of whether you have started drawing an income from it or not.

Die after 75 and things (while better on the life satisfaction front) aren’t going to be quite as good on the pension front.

Your heirs will pay a 45% rate if they take the money as a lump sum (although this will probably be changed later to the recipient’s marginal rate).

If instead they take it as an income (so they continue drawing money from the pension), they will just pay income tax at their marginal rate, rather than a special rate of IHT on the money.

Money not withdrawn will continue to roll up in the fund tax free. The table below from Hargreaves Lansdown shows the details of the old and new system.

If you die before 75
  Old rules New rules
Lump sum • Tax free or 55% tax if in drawdown • Tax free
Income • Taxed as income (via an annuity or drawdown)
• Option available only to dependants
• Tax free if taken via drawdown
• Taxed as income if taken via an annuity
• Option available to any beneficiary
If you die after 75
  Old rules New rules
Lump sum • Subject to 55% tax • Subject to 45% tax (unless paid as income)
Income • Taxed as income
• Option available only to dependants
• Taxed as income
• Option available to any beneficiary
Death benefits may be subject to a lifetime allowance tax charge.

This is clever stuff. There was a small problem with the last major changes made to the system. These allow everyone, regardless of the size of their pot, to take their cash as and when they like, subject to their marginal rate of income tax. That would mean a maximum tax rate of 45% during a lifetime (and mostly one of 20%).

As a result, the incentive was to spend as much of the pension as possible pre-death to avoid the 55% tax rate. Clearly, the risk then is that people would spend too much too soon. This move takes that problem away, and instead incentivises people to be as careful as possible with their pensions. The less they spend, the more they can pass on either tax-free or at relatively low rates.

A fantastic tax dodge for the already wealthy

There are a few things worth saying on this. The first is that not a huge amount of money will end being passed on entirely tax-free. There will be a few ‘lucky’ people. If your 73-year-old mother dies with £1m in her pension pot, you get to roll it up tax-free and take a tax-free income from it at will, even although a lot of it came from the taxpayer in the first place. 

But not many people have enough pension cash to enable them to live a full retirement and still leave a fortune. Throw in the fact that the average age of death is over 75, and you can see that the average pension pot will end up being paid out to beneficiaries subject to their marginal rate of income tax.

The second point to make is that as such, for most people, the new pension tax plans are remarkably similar to the ‘gift tax’ plan we have been pushing for – this would replace IHT with an income tax on all money received by an heir.

And the third is that it is all great news for anyone well-off who is looking for a new way to avoid IHT. A letter to The Times puts it nicely: “those fortunate enough to have spare earnings can place them untaxed into certain untaxed pension plans and then on death pass them untaxed to their beneficiaries….  those who need all their earnings just to get by with daily living, will have no such tax benefits.”

As one adviser put it, advice on pensions will now need to “dovetail” with that on IHT. Quite. What were once personal pensions are now to be “family assets that can be very effectively used for intergenerational planning”.

Subject to the current Lifetime Allowance, families can pile £1.25m into a pension over time and leave it to be drawn down (or topped up) by descendants as they see fit. I suspect that George Osborne doesn’t want us to go on about that bit too much.

Is this really about cutting the long-term public sector pensions bill?

This is all good. But I think there might be even more to it than we think. This government is a great fan of Richard Thaler’s book Nudge. And this new policy nudges people in all sorts of directions.

It encourages saving without spending. And if it cascades at least some pension money down generations, it should eventually take some pressure off the welfare system.

But it also, and this I think is crucial, makes defined-benefits pensions (the kind most used in the public sector) look relatively less attractive.

Given the choice of a regular inflation-linked income for yourself for your lifetime, or a lump sum from which you might create a smaller – but not dissimilar – income and then leave some money to your kids, what might you choose? Note that recent research from the Association of Investment Companies showed that 67% of people said they were put off buying an annuity by the fact that they would be “unable to pass anything on to friends and family”.

What if these moves lead to a clamour from public sector workers to leave the security of retiring on the state, in order to join in the private sector fun? Transfers out from final salary schemes are very expensive in the short term. The average transfer value comes in at about 20 times the expected pension, and the government has nothing set aside for this.

But it’s a good deal for the state in the long term – everyone who transfers out and lives longer than 20 years represents a saving.

And what if then, in the name of having more to pass on to the kids, public sector workers agree to reform the public sector pension system – the taxpayer gets to make fewer expensive commitments, but public sector staff get to control their cash in the same way as those of us in the private sector do.

Perhaps when Osborne came up with this policy his mind was not on helping wealthy families stay wealthy with a little extra IHT avoidance – but on a nudge towards creating some far greater reforms. That would be nice. 

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